Mike Lipper’s Monday Morning Musings
VALUE INVESTING WILL BE SUPERIOR
BUT IT MAY HAPPEN AFTER THE RECESSION
Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –
Current Inputs
A few weeks ago, one of our perceptive readers asked what advice I had for his good friends that were managers of value stock portfolios. My unexplained response may have seemed nonsensical in the face of relatively poor performance compared to market. I should have explained my thinking. My reply was focused on the business of providing investment advice. I saw a short-term continuation of poor relative performance leading to less money going into these portfolios and a significant number of the managers withdrawing from the business. Lower prices often result from fewer value buyers participating in the market. Without new performance seeking money in the markets the remaining portfolio managers will need to liquidate some or eventually all their holdings. Typically, they will sell their most liquid holdings first and be forced to sell their less-liquid positions when that is all they have left. These sales will be at bargain prices for those that have the cash to take advantage, but there will be few with the cash, courage, and foresight to take advantage of these great bargains. These insightful managers will have less competition and thus they can earn premium level fees.
Recently I reviewed the performance of a large Planned-Giving Fund run by a well-known and respected manager with a recognized value bias. In looking over their performance record, it was superior for ten years, but not for shorter time periods. Just this week we were informed that a” deep-value” manager was closing his shop, as he was no longer able to produce the good returns he had generated in the past.
These inputs led me to explore the structural reason why this group of intelligent, formerly good performers, were not doing better in a market that was performing extremely well. Like many analysts who are closet history students, my search for an explanation focused on recent US financial history and recorded history from Biblical and Ancient societies.
Last Ten Years
Because government promoted home ownership, various government subsidies and tax credits led to excessive ownership of homes by those stretched in their ability to support mortgages and the reasonable upkeep on home purchases. In some cases the buyers lied on their applications, but much more significantly lied to themselves and their families as to the predictability of their income and wealth.
In the aftermath of the mortgage crisis the government focused on the mis-selling and mis-labeling of tranches and ended up penalizing the financial industry with burdensome regulation and capital requirements. Further, Central Banks pumped money into the market in what came to be known as “quantitative easing”. This has led to a ten-year period where interest rates have been kept artificially low, depriving savers of the rates that paid them not to spend, leading to a global shortage of savings. More importantly, low rates and the availability of capital has led both commercial banks and non-bank financials to make commercial loans at interest rates which encouraged undisciplined credit extensions. Much of this money went to marginal firms for capacity expansions. This has hurt the value investor, as demonstrated by their poor investment performance compared to other investors.
Companies that value investors favor have the following characteristics:
- Strong balance sheets (under-utilized borrowing power)
- Physical assets where the current market value is larger than the depreciated book value
- Close to impregnable market penetration of good customers
- Unique and highly prized intellectual property
- Respected in-depth management
- Stable shareholder base
It takes many years if not generations to build these. The field of competition changes when marginal companies with a poor financial record and large debt can acquire even more debt at low cost. Often, when marginal companies build excess capacity they fight for market share. They do this by lowering prices, which in turn devalues the more sound companies. With a more leveraged balance sheet the marginal company can report faster earnings growth than the value focused company, at least for a while. Thus, in a period where growth is most valued, the marginals will be the more productive investments, until the next recession.
Ancient History + Human Nature
The Bible and archaeology have recorded various agricultural cycles, often tied to weather but also the expansion of crop or grazing land. Humans are driven by fear and greed. When they are in rough balance, humans tend to be both disciplined and careful. However, when either side is predominant humans tend to do extreme things and concentrate all their resources to gain more wealth/power or horde them to avoid current or future crises. When a mass of people do the same thing, like all going to one side of a boat, they can capsize the boat. That is why we have always needed recessions to correct the excesses of a prior period. I see nothing that has repealed this need and thus I expect we will have a recession at some point.
Where are We Today?
While I can’t give a date for the top of the market prior to the beginning of the next recession, nor the percent of the market gain, I can make the following observations:
- Currently, the US stock market is being led by the NASDAQ composite, made up mostly of tech and services providers. However, this past week the stocks listed on the New York Sock Exchange had a higher percentage of gainers 77%vs. 69%. Perhaps the valuation gaps are too great - NYSE p/e 18.47x vs NASDAQ p/e 23.67x. If the rate of gain slows, perhaps yields will be more important - NYSE 2.16% vs. NASDAQ 0.99%.
- Despite the strength of the equity market NYSE volume is flat compared to a year ago. The absence of speculative enthusiasm for listed stocks suggests there is more upside ahead.
- While it is broadly proclaimed that the Federal Reserve won’t raise interest rates this year, this week the average interest rate offered by savings institutions rose 5 basis points to 0.65 bps. I interpret this as savings banks encouraging more deposits for them to loan out. This may support the surprise 3.1% first quarter GDP announcement. I have always believed that the Fed is a follower and not a leader on setting interest rates.
- Each week the WSJ tracks the prices of 72 securities, currencies, and commodities. Until this week, gainers outnumbered the losers, this week they are exactly even.
- The bond market is often more attuned to changing financial conditions. In the latest week yields on high quality bonds rose 14 bps, while the yield on intermediate credits declined 4 bps. [Prices move inversely to yields.] This suggests that bond investors are concerned about the future value of the highest quality bonds.
What to Do with Value Funds/ Managers
As a portfolio manager of portfolios of mutual funds, we invest globally in both growth and value focused funds. I expect the more growth-oriented funds to provide both more appreciation and volatility. The value-focused funds will probably go down less in poor markets. However, when interest rates go up, as I expect them to do before the next presidential inaugural, the value merchandise should do better and will receive a reasonable amount of M&A activity.
What Do You Think?
Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/04/contrarian-observations-not-predictions.html
https://mikelipper.blogspot.com/2019/04/not-yet-peak-luck-lessons-weekly-blog.html
https://mikelipper.blogspot.com/2019/04/investing-in-quality-for-growth-or.html
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A. Michael Lipper, CFA
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